Inequality, the crash and the crisis: Part 1 “The defining issue of our times”

Today we publish the first of three articles on inequality and the crisis by Stewart Lansley, visiting fellow at The Townsend Centre for International Poverty Research, Bristol University and the author of The Cost of Inequality: Why Economic Equality is Essential for Recovery, Gibson Square, 2012. He was one of the speakers at the 2012 OECD Forum session: How Is Inequality Holding Us Back?

Does inequality trigger economic instability? A few years ago this was a issue that did not register on the political Richter scale. Nor did it attract much attention amongst professional economists. As James Galbraith, the economist son of John Kenneth Galbraith, has put it, those few working in inequality research were in an economics “backwater”. Proving his point, the academic Journal of Economic Literature has no section examining inequality and economic instability.

There is one key reason for this lack of interest. For the last thirty years, the economic orthodoxy has been that inequality is a necessary condition for economic success. We can have greater equality or faster growth but not both. That orthodoxy emerged out of the global crisis of the 1970s when, it was claimed, the move towards more equal societies in the immediate post-war decades had gone too far and had led to economic sclerosis. What was needed to put economies back on an upward and sustainable path was a stiff dose of inequality.

Since the late 1970s that theory – for theory it was – has been put to the test in a real life experiment in both the US and the UK, and more latterly in a number of rich countries. As a result, the income gap in America and Britain has grown to levels last seen in the inter-war years. So has the experiment in “unequal market capitalism” worked in the way predicted by the theory? The answer appears to be no. The income gap has surged but without the promised pay-off of wider economic progress.

On all measures of economic success bar inflation, the post-1980 era of rising inequality has a much poorer record than the egalitarian post-war decades. In the UK, growth and productivity rates have been about a third lower since 1980 than in the post-war era, while unemployment has averaged five times the level of the 1950s and 1960s. The three post-1979 recessions have been deeper and longer than the shallow and short-lived ones of the two post-war decades. The main outcome for the countries that have embraced the post-1980 model of market capitalism most fully has been economies that are both much more polarised and much more fragile, culminating in the great crash of 2008 and today’s increasingly prolonged and intractable crisis.

So does this mean the theory is fundamentally wrong? Do high levels of inequality lead to economic collapse? Was rising inequality from the 1980s in fact a central player in driving the global economy over the cliff in 2008, and in the dogged persistence of the current slump?

The official view is that inequality played no part in the present crisis. The report of the bipartisan US Financial Crisis Inquiry Commission into the causes of the 2008-9 Crash, published in January 2011, for example, failed to mention “inequality” once in its 662 page report.

Two years ago the handful of economists who argued that inequality was the real cause of the current crisis were easily dismissed as an insignificant and heretical minority. The political consensus remained that inequality was not an economic issue. Yet gradually, opinion is beginning to turn. At the 2011 World Economic Forum in Davos, Min Zhu, former Deputy Governor of the People’s Bank of China and a special adviser at the International Monetary Fund, told his audience: “The increase in inequality is the most serious challenge facing the world.” In his economic address in Kansas last December, President Obama attacked the long period of stagnant earnings facing most Americans, or what he called the erosion of the “basic bargain that made this country great”. “But this isn’t just another political debate’, he continued, ‘This is the defining issue of our time.”

At the OECD’s annual conference in Paris last month, the packed agenda was dominated by the issue of the growing divide, while the IMF has produced several reports that question the orthodox explanation of the role of inequality. In one study, two IMF economists, Andrew Berg and Jonathan Ostry, argue that the 1970s theory – by Arthur Okun in his highly influential book Equality and Efficiency, The Great Trade-Off – has failed to stand up to real world application: “When growth is looked at over the long term, the [efficiency/inequality] trade-off may not exist. In fact equality appears to be an important ingredient in promoting and sustaining growth.”.

Not only has the rise in inequality failed to deliver on faster growth, history shows a clear association between inequality and instability. The great crashes of 1929 and 2008 and the deep-seated recessions that followed were both preceded by sharp rises in inequality. In contrast, the most prolonged period of economic success and stability in recent history – from 1950 to the early 1970s – was one in which inequality fell across the rich world and especially in the UK and the US.

Of course, association is one thing, causation is another. In part 2, we will look at the reasons why the link may run from inequality to crisis, at why economies that allow a small minority to colonise an increasing share of the economic cake hike the level of economic risk and the likelihood of implosion.

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It is possible to create a dynamic model of the impacts of inequality on economic by use of an analog simulation. The initial work,in conjunction with Dominican University in California was inspired by Phillip’s work in the 50’s, where he modeled complex non-linear relationships of stocks and flows with an amazingly ingenious hydromechanical analog simulator. The Dominican working paper is available at: https://sites.google.com/a/dominican.edu/econo-physics/working-papers, and contains reference to Phillips device and his work on control loops in economics.

By using a fluid dynamics analog rather than Phillips tanks and slotted graphs and valves, the model shows that for a given structure, there is, as hinted by Kuznets, a dynamic of wealth distribution that has a major impact on economic performance. Essentially, the model looks at the momentum in flow over a surface to determine growth potential.
If those at the leading edge of the economy extract too much momentum from the flow, those downstream will have reduced spending power and economic efficiency will suffer. However, there is an optimum, as with no inequality, there is no circulation of the flow, and thus no growth.

In the working paper, we show that the growth coefficient produced by the model replicates the income distribution of the US Congressional Budget Office 1979-2007 data, and a comparison of the Swedish and U.S. economies in the same time period show that attempts to maintain the assets of the leading edge of the economy will, beyond a certain point, lead to extreme instability and economic stall, and that performance at the optimum level greatly enhances overall growth.

What the model shows is that, for a given economy, attempts at austerity when there is insufficient transactional momentum in the economy are counterproductive and destabilizing, essentially a region of reversed commands, very much the conditions of a liquidity trap. While the model was originally intended as a simplified policy flight simulator for evaluating environmental and resource impacts on economic performance, (I am not an economist but currently a guest at Lawrence Berkeley National Laboratory in the field of microbial ecology) it does show the power of analog simulations to study complex systems without the rigid constraints of pure mathematical models.